Warning: Depreciation that costs you money?

A Labor-lite budget gave us negative gearing lite, but the depreciation changes might be about to cost you money.

One of the most-interesting but least-talked about things to come out of the budget is the change to depreciation in negative gearing.

Most of the media seemed to have missed it. I kind of missed it too. I thought it was just some small-fry changes aimed at heading off any pressure to seriously reform negative gearing.

But now I’m not so sure.

And the truth is that if these changes are implemented full-stick, it could cost you thousands of dollars every year and/or make it harder to on-sell your property.

In case you missed it, the proposed change will limit plant and equipment depreciation deductions to only those expenses directly incurred by investors.

Basically, if you didn’t write the cheque yourself, you don’t get to depreciate it.

This has the potential to shave several thousand dollars a year off a property’s cash-flow stream.

Consider the following three examples (and I tip my hat here to Louis Christopher at SQM Research, who’s done some great work helping us get a grip on the changes):

On-selling a New Build

Say you purchase a unit off the plan. There’s significant plant and equipment depreciation benefits that come with newly-built dwellings. We could easily be talking about five or six thousand dollars in the first year on a median priced unit in most cities. It tapers away after that, but even 6 or 7 years down the track we could still be talking about a couple of thousand a year.

Over the life of the property, we’re talking about something like twenty grand.

But under these changes, now, when you sell the property, the incoming buyer no longer has access to that depreciation stream. It’s gone.

And say you’re circumstances change, and you have to sell after only one or two years. The incoming buyer has no capacity to claim a depreciation deduction, not just in the year they buy, but in all future years.

They could lose up to twenty grand’s worth of value.

Hard to say how much that will hurt you sale price, but it’s certainly not going to help.

One thing that’s not clear is what happens if you flip the property before completion. Have you paid for the plant and equipment, or has the new buyer? The government needs to clarify this one.

All New Builds?

The above example assumes that the first buyer is the one paying for the plant and equipment. However, in the strictest sense of the word, the developer is the one who pays for it. In that sense, only the developer has a right to claim depreciation.

This would be a pretty hardcore interpretation of the change – basically purchasers of off-the-plan developments wouldn’t be able to access any depreciation benefits.

Most people think that this isn’t what the government intends, but now that the media has moved on, they might be able to slip it through. We’ll have to see.

It also creates a bit of a grey area. If I do like a one into four townhouse build, and then sell each one individually, what do I need to do to make sure that the new purchaser is the one paying for the plant and equipment in the eyes of the law?

The Fresh Reno

Lastly, say I buy a nice little doer-upper and spend $200K on plant and equipment. If I now sell the property to you, even if the paint is still drying, you cannot depreciate any of the plant and equipment.

No need to get any clarification here. This is exactly what the government has in mind.

The Timing

There’s a bit of ambiguity here that needs to be clarified. That clarification will happen when the budget passes through parliament over the next couple of months.

However these changes are time-stamped with the budget on May 9. That means that these changes will affect any property bought and sold today, even though we still don’t quite know what the full ramifications are.

That’s not ideal. Realistically, if you’re buying, you’re going to have to assume the worst – even though the worst is pretty hard-core for off-the-plans.

If you’re selling, you’ll need to find a buyer that isn’t assuming the worst to get a premium price for your property.

The Up-shot

At the end of the day, investors have just lost a benefit that was worth potentially several thousand dollars a year.

As I said, that’s not going to help prices.
Louis Christopher reckons it will help cool investor demand in the short term. It will be interesting to see. Most investors I know are pretty savvy with their depreciation schedules, and factor it in to their offer prices – but I tend to move in a savvy crowd.

Will your average mum and dad investors care? They should, but will they?

This also gives us a look at negative-gearing lite. Labor wanted to end negative gearing. This is a small, partial step. If it doesn’t move the dial, it will open the way for further reforms.

If it does crimp investor demand and the market softens, the government will be vindicated in their softly softly approach. It will be interesting to see.

So yeah, still waiting for a few details, but something to be on top of here.

Comments

When a company buys another company, they can elect to “consolidate” the assets and liabilities of the acquired company and revalue them to market value. This often results in a step up in the value of depreciable plant and equipment as their depreciated values are often lower than market values (indicating perhaps that actual useful lives are longer than the ATO tax depreciation schedules assume).

Yes, that’s exactly how I’ve seen two other savvy property commentators describe it. Two contracts. Contract one for house, contract two for plant and equipment as second hand items.

My questions are;
1. Will the ATO likely disallow the deductions as they are primarily a tax avoidance mechanism? I.e. Is there a valid ATO-acceptable alternative explanation for doing this?
2. How will lenders view finance on a two contract sale? Will they finance the first contract but not the second? (Maybe the seller carries-back a second mortgage on the second contract? All of a sudden vendor finance goes mainstream, which it should.)
3. This should heavily impact fully-furnished properties. Those in mining and holiday areas. Wow, that’s pain on top of pain for those folks.

obviously there will be adjustments everywhere. the market will pay value, either through gross purchase or net purchase. investors will sharpen their pencils and negotiate anyway up or down.
but beware a government introducing such measures as it smells like the thin edge of the wedge.

As a Quantity Surveyor, and actively involved in the preparation of Tax Depreciation Schedules for investment properties, I believe those interpreting the changes as applying to new builds are reading too much into it (at least I hope they are).
Those saying the developer is the first owner need to ask:
– Is the developer deriving a passive income from the plant and equipment (say dishwasher): No
– Is the developer using the plant and equipment: No. It remains unused (i.e. new)
– Is the developer depreciating the plant and equipment: No

I cant see how separating values for house & P+E will work in practice. A depreciable item is a depreciable item, irrespective if it’s caught up in a contract or separately identified.

In this new universe, you’ll probably want to maximise the value attributed to capital works, not the other way around.

The poor soul who proposed this got it mixed up with goodwill in a company/business: you see, if you don’t separately identify (and value) all the plant + Eq etc items when you acquire a business then it’s all considered goodwill. End of Story. What one seeks to do is identify everything conceivable and push those valuations as far as you are game. Depreciation on Plant + Eq etc is deductible. Goodwill cant be deducted in any way shape or form.

I surmise that the changes to the depreciation rules will mean that formerly depreciable items will become part of capital works deductions, i.e. all things that are necessary for the supply of a residential premises will be deemed comprising the capital works.

While you might not get the annual depreciation charge, at least there’s the capital works deduction. if you have it.

I forecast that if this proposal gets off the ground, there’ll be a lot more claims for “repairs and maintenance” in the future. Why? If a depreciable item fails, and is replaced, that replacement is then also depreciated. I will calling my replacement capital items repairs and maintenance. If that wont work,

Have I studied the accounting standard AASB 3 “Business Combinations” or the ATO’s Market Valuation for Tax Purposes? Nope. Since IFRS was released, I cant be bothered, moreover, it is not relevant to my client base and target market. As for Tax Consolidation – same. It interests me even less than reading the Master Tax Guide again (once is enough for anyone!).

My question back is, supposing you got someone to agree to let you apply these sophisticated techniques you speak of, how long would it take you, and what would be the resulting fee?

The way I understand things is that the ability to depreciate anything is to have a tax advantage now rather than later i.e. if you claim 10,000 in deductions against your taxable income you don’t pay tax on that 10k at what ever your current rate of tax. Some investors are actually loosing a bucket load of cash as well as claiming depreciation which is dumb however buying cashflow positive sorts this one out.

When you sell the house however that 10k has reduced the cost base and you are assessed on that extra income after the 50% CGT discount which is the big bonus to property owners holding for more than 1 year.

We have benefited from negative gearing however have been amazed at how good its been.

If both sides of politics had the common sense (yea big dream there) to get together for the benefit of the country and not those of us savvy enough to get into property they would work on reducing the CGT discount which would take some of the heat off the property market which would assist those non smashed avocado eating home owning wannabees as well as bringing the current OTT house prices down for investors.

To me this means that depreciation costs will be capitalised and therefore only realised upon a future sale via reduced capital gains tax. As others have suggested assets of a company can be revalued through write downs (and up) with tax implications. As Jon pointed out the Net effect would be to increase holding costs each year effecting negatively geared properties the most. “Mum and Dad” will be the hardest hit and wealthier investors will be able to take advantage of any “fire sales” caused by this policy.

I hate to disappoint those who see these proposed changes as the end to the need for Tax Depreciation Schedules prepared by Quantity Surveyors(QS).
The main reason you require the services of a QS is to claim the Division 43 capital allowances (building) depreciation as the ATO recognises that the QS is one of the few industry professionals capable of establishing the original construction cost. This has not changed!
As far as a QS is concerned (speaking as one), the only drop off in work will be from those post 9 May 2017 acquisitions where the original property was constructed prior to 15 Sep 1987, thereby not qualifying for Division 43 deductions or the Division 43 deductions have expired, AND where this same pre 15 Sep 1987 property has NOT undergone any capital improvements (Division 43 renovations and improvements). Pre 15 Sep 1987 properties will still require the services of a QS if they have undergone Division 43 renovations and improvements, however, the viability of the service will come down to the extent of the renos and the time period that the owner intends to rent the property. Other properties that may not require a Tax Depreciation Schedule are those where the previous owner passes on the Division 43 amount.
Moving forward, looking to invest in property, running the numbers, etc…get advice from a QS, that’s my tip!

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